SYNOPSIS: Shoddy Bush Economic management is strangling long term growth

Three years ago, after the collapse of Long Term Capital Management, U.S. financial markets were in crisis. For a few weeks it looked as if the economy would succumb to panic, to self-fulfilling pessimism. Then the Fed surprised the markets by cutting rates without waiting for its next scheduled meeting. Confidence was quickly restored, and Alan Greenspan was promoted to demigod status.

But it has been more than seven months since Mr. Greenspan tried to work his magic a second time, again surprising the markets with an inter-meeting cut. Since then he has cut again and again. Yet the Fed's latest survey of the economy offers few signs that a turnaround is imminent.

This slowdown, it turns out, is different. We are not in the midst of a financial panic, and recovery isn't simply a matter of restoring confidence. Indeed, excessive confidence may be part of the problem. Instead of being the victims of self-fulfilling pessimism, we may be suffering from self-defeating optimism.

The driving force behind the current slowdown is a plunge in business investment. It now seems clear that over the last few years businesses spent too much on equipment and software, and that they will be cautious about further spending until their excess capacity has been worked off. And the Fed cannot do much to change their minds, since equipment spending is not particularly sensitive to interest rates.

Still, as former Treasury Secretary Larry Summers says, you don't have to refill a flat tire through the puncture. To reflate the economy, the Fed doesn't have to restore business investment; any kind of increase in demand will do.

How might demand increase? Consumers, who already have low savings and high debt, probably can't contribute much. But housing, which is highly sensitive to interest rates, could help lead a recovery. Even more important would be a turnaround in the U.S. trade balance. America's deficit has lately been running at 4.5 percent of G.D.P., three percentage points higher than it was as recently as 1997. Reversing that trend — which would mean both exporting more and buying domestic instead of imported goods — could deliver a big boost to the economy.

But there has been a peculiar disconnect between Fed policy and the financial variables that affect housing and trade. Housing demand depends on long-term rather than short-term interest rates — and though the Fed has cut short rates from 6.5 to 3.75 percent since the beginning of the year, the 10-year rate is slightly higher than it was on Jan. 1. The trade balance depends on the value of the dollar — and the dollar, which usually falls when the Fed loosens monetary policy, has actually risen over the past seven months.

There are, I would argue, three reasons that the dollar and long-term interest rates have not moved in the right direction. First, for what it's worth, Bush administration officials have been saying all the wrong things. I don't know if anyone in the financial markets still takes Treasury Secretary Paul O'Neill seriously, but his extravagant statements on behalf of a strong dollar — he recently declared that if he changed his mind on the subject, he would hire Yankee Stadium and a brass band to announce it — are the opposite of helpful.

Second, the Bush tax cut which offers only small tax cuts in the near future but promises much bigger cuts in the more distant future — is exactly the kind of fiscal policy that you would expect to drive up long-term interest rates and have a depressing effect on the economy.

Most important, however, is the way both long-term interest rates and the dollar have been sustained by investor optimism — by the belief that Mr. Greenspan can do again what he did in 1998. This belief deters investors from buying long-term bonds, because they expect interest rates to rise again; it induces investors to keep buying dollars, because they are still bullish on America. And so optimism, paradoxically, helps keep the bad times rolling.

Sooner or later, of course, investors will realize that 2001 isn't 1998. When they do, mortgage rates and the dollar will come way down, and the conditions for a recovery led by housing and exports will be in place. But for the time being delusions of an instant return to prosperity stand in the way of a real economic turnaround.